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Is a U.S. ​“Soft Landing” Still in the Cards?

For some time now, central banks in the developed world have been leaning heavily on the ​“soft landing” scenario. That is, that economies were strong enough to withstand longer periods of restrictive monetary policy without wreaking too much damage on real activity and/​or the labour market. For the most part, that narrative held up reasonably well — but of late, there are signs of trouble emerging.

Consider the most recent Federal Open Market Committee (FOMC) meeting. The U.S. Federal Reserve (Fed) left administered rates unchanged but made it clear that concerns are now shifting to how tight current policy is in the context of employment, instead of just inflation. That’s a dovish departure from prior messaging and portends a likely rate cut at the next FOMC meeting in September.

However, by waiting another few months to begin easing, the Fed is implicitly lending more credence to the ​“soft landing” scenario. In essence, it’s saying that it believes the U.S. labour market can handle some additional time under historically restrictive monetary policy without cracking.

The data is beginning to strike a different tune, though. Indeed, the most recent non-farms payrolls report flagged a rising unemployment rate which was high enough to trigger the much-discussed ​“Sahm Rule” (See Chart 1).¹ Meanwhile, leading indicators on the health of the jobs market forecast problems ahead, with initial jobless claims and layoff notices rising.

Chart 1: The Track Record of the ​‘Sahm Rule’ in the U.S.

Narratives are powerful. Having the ​“Sahm Rule” triggered at a point when the U.S. yield curve has been inverted for over a year breathes more life into the view that a recession is close at hand in the U.S., and the Fed may be wrong on the ​“soft landing.” The former was a key catalyst for the broad risk sell-off at the end of July and early August, while the latter has resulted in Overnight Index Swaps (OIS) pricing in rising odds of 50-basis point cuts for the September, November, and December Fed meetings.

Broad Market Risks

Contributing to the bearish tone for risk assets of late are developments in Japan. With the Bank of Japan (BoJ) now entrenched as the most hawkish central bank among advanced economies, higher rates in Japan lead to repatriation of flows and a stronger Japanese Yen (JPY). That triggers broader market pain via two channels: first, it disrupts popular carry trades that relied on cheap JPY funding. Second, it hits Japanese exporter revenues. Both lead to a drawdown in Japanese stocks, and a large amount of position rebalancing in the macro space.

Additionally, while the recent round of U.S. earnings was far from cataclysmic, there are clear signs that momentum is fading. At the same time, geopolitical risks are rising in the Middle East.

We’re sympathetic to views that the market is too aggressive in pricing Fed easing over the coming months. Indeed, as the Fed begins to switch regimes and markets chart the course of the coming cycle, price action won’t be orderly. 

BoC Policy Path 

In Canada, on the heels of rate cuts for the June and July meetings, respectively, the Bank of Canada (BoC) is expected to cut at each of the remaining meetings on the calendar (September, October, and December) and into 2025. We’re a bit circumspect on the BoC’s growth forecasts for the coming quarters (1.5% quarter-over-quarter in Q3 and 2.8% quarter-over-quarter in Q4). That’s largely as we envisage household spending potentially falling under considerable pressure from mortgage refinancing risk over the coming years. Forward swaps are pricing the central bank to stop easing once it gets to the 2.50% range for the overnight rate, but there are risks that they could dip below that level during the course of this easing cycle (See Chart 2).

Chart 2: Market Expectations of Orderly BoC Easing Cycle

To us, it makes sense to shift portfolios to reflect a slightly more defensive posture relative to earlier this year. That means a preference for U.S. fixed income with some allocation to investment grade credit. On a sectoral level, a gradual normalization of yield curves should become a more prominent theme into Q4, and favours financials as an outperformer. We see consumer discretionary as a laggard and retain a bias to remain underweight that sector.

Things to Keep an Eye On

Hybrid Portfolio Ballast 

With central bank policy rates well above neutral for most regimes, a more traditional interest rate environment has emerged. It does feel like this shift is structural, meaning that we’re not likely to head back to zero rates any time soon. That should mean increased allocations to fixed income in portfolios over time. 

Having said this, the rise of alternative assets over the past decade means that the popularity of the traditional 60/40 portfolio isn’t likely to come back in full — particularly as the use of alternative assets has been shown to improve a portfolio’s overall efficiency.² For instance, exposure to long-short equity strategies, such as the BMO Long Short US Equity ETF (Ticker: ZLSU), would have improved a portfolio’s overall risk/​return profile in the context of the recent sell-off.³

Additionally, ​“buffer” ETFs like the BMO US Equity Buffer Hedged to CAD ETF – July (Ticker: ZJUL) can provide ballast for portfolios.⁴ These ETFs help investors mitigate losses during periods of intense volatility, while also allowing some participation to the upside. Dividends paid from the underlying are not subject to the downside buffer or the price cap.

Canadian Bonds

The Bank of Canada has cut rates at each of its last two meetings (June and July). For now, we’re in-line with consensus expectations for additional 25-bps cuts for the September, October, and December meetings. But the path beyond that is far less certain yet nevertheless an important consideration for investors.

Forward swaps are pricing the BoC to end the current easing cycle at 2.75% — which is in keeping with where the Bank sees its neutral rate. However, given the stock of household debt and the large number of mortgages that will need to be refinanced in the coming years, we expect that the downside risks to domestic consumption will hold sway. That means that there’s a good chance that the BoC will have to shift policy towards accommodation (meaning below the neutral rate) at some point. That implies the potential for further upside for the BMO Government Bond Index ETF (Ticker: ZGB).

U.S. Front-End Performance

While a recession in the U.S. isn’t quite the base case scenario, it’s clear that the spectrum of possibilities should include a meaningful growth slowdown. The Fed is expected to start easing rates as soon as the September meeting, which suggests that curve normalization will remain a theme into Q4. However, softer data may necessitate more easing to be priced into the USD OIS curve. To us, that suggests legging into ideas that capitalize on outperformance in the front-end of the U.S. Treasury curve. The BMO Short-Term US Treasury Bond Index ETF (Ticker: ZTS) can help take advantage of this theme.

Changes to Portfolio Strategy^*

*The portfolio holdings are subject to change without notice and only represent a small percentage of portfolio holdings. They are not recommendations to buy or sell any particular security.

Asset Allocation:

• We’re a bit more cautious when it comes to the risk backdrop from here. That’s largely because we see compelling signs that fundamentals in the U.S. are shifting, and there is now far more two-way risk when it comes to indicators such as labour market data. While a recession shouldn’t be the base case scenario, the odds have risen and we don’t think the time is ripe to take advantage by going long risk assets
  

• Additionally, the recent batch of earnings releases tell us momentum is waning at the margin. At the very least, that points towards shifting from overweight equities to more neutral.
  

• As mentioned above, our preference is to remain slightly defensive until there’s a more predictable cadence for how the Fed will proceed from here. We like fixed income relative to cash or equities. We see scope for investment grade fixed income to continue to perform, as well.

Equities:

• We’re cautiously optimistic on broad risk going forward, and the shifts in the make-up of our balanced portfolio reflect these changes.

• In keeping with the defensive posture, we’re sticking with the theme of Quality and Low Volatility as factors. Indeed, both tend to complement each other from a sector exposure perspective
  

• Our core consists of exposures such as the BMO MSCI USA High Quality Index ETF (Ticker: ZUQ) alongside the BMO Low Volatility Canadian Equity ETF (Ticker: ZLB) and BMO Low Volatility US Equity ETF (Ticker: ZLU).
  

• We have exited our positions in BMO Covered Call Technology ETF (Ticker: ZWT) and BMO Equal Weight REITs Index ETF (Ticker: ZRE). As we head into a likely period of slower growth, both of the underlying sectors should underperform. While we acknowledge that covered call strategies can perform during these periods, our preference is to reduce exposure to the Technology sector for now.

Fixed Income:

• Given that the Fed has kept policy rates steady for over a year as inflation has declined, the real policy rate is now the tightest it has been since 2007. History has shown that an extended period of restrictive policy can sometimes impair real activity, necessitating deeper policy rate cuts than the market expects.⁵

• With that in mind, we expect curve normalization to be a central theme into Q4. As markets price in the right cadence for Fed rate cuts, we like switching our U.S. Treasury exposure to the front-end of the cash curve. That means adding the BMO Short-Term US Treasury Bond Index ETF (Ticker: ZTS) as a tactical position.

• At the same time, we remain circumspect of an orderly easing cycle in Canada. Indeed, we do not think the BoC is paying enough attention to the risks of an extended slowdown, given the considerable degree of mortgage refinancing risks. A way to play this theme is to look at incorporating positions in the BMO Government Bond Index ETF (Ticker: ZGB).

• We continue to like yield plays in the front-end of the CAD curve, as well. For instance, the BMO Ultra Short-Term Bond ETF (Ticker: ZST) offers an attractive yield relative to CAD bills.

Non-Traditional/Hybrids:

• We’re adding the BMO US Equity Buffer Hedged to CAD ETF – July (Ticker: ZJUL) to our portfolio. Given that broad risk momentum appears to be waning, we feel this product fits with the cautious backdrop and helps to mitigate some downside risk to the portfolio while also allowing for some topside participation.

• Indeed, a ​“target outcome strategy” is often useful for portfolio support during periods of uncertainty. This fund should augment the diversification approach for this part of the portfolio alongside our other non-traditional hybrid positions — including the BMO Long Short US Equity ETF (Ticker: ZLSU).

Stats and Portfolio Holdings

BMO Global Asset Management, as of July 31, 2024. Past Performance is not indicative of future results.

Portfolio Holdings^†

Portfolio Characteristics

Fixed Income Sector Breakdown

Weighted Average Term: The average interest received by a bond investor, expressed on a nominal annual basis.

Weighted Average Current Yield: The market value-weighted average coupon divided by the weighted average market price of bonds. 

Weighted Average Yield to Maturity: The market value-weighted average yield to maturity includes coupon payments and any capital gain or loss that the investor will realize by holding the bonds to maturity. 

Weighted Average Duration: The market value-weighted average duration of underlying bonds divided by the weighted average market price of the underlying bonds. Duration is a measure of the sensitivity of the price of a fixed income investment to a change in interest rates. 

Weighted Average Coupon: The average time it takes for bonds to mature in a fixed income portfolio.

The portfolio holdings are subject to change without notice and only represent a small percentage of portfolio holdings. They are not recommendations to buy or sell any particular security.

Source: Bloomberg, BMO Asset Management Inc., as of August 14, 2024.

BMO ETFs Guided Portfolio: Quarterly Fixed Income Strategy (Q3 2024)>

¹ The Sahm Rule identifies signals related to the start of a recession when the three-month moving average of the national unemployment rate rises by 0.50 percentage points or more relative to its low during the previous 12 months. It is meant to serve as a theoretical indicator of possible recession. 

² Denis Schweizer, Portfolio Optimization with Alternative Investments, January 2008.

³ Based on ETF market performance, which has been positive. Unable to use in performance data because ETF is less than a year old. Please refer to historical NAV since inception (October 2, 2023).

⁴ BMO Buffer ETFs seeks to provide income and appreciation that match the return of a Reference Index up to a cap (before fees, expenses and taxes), while providing a buffer against the first 15% (before fees, expenses and taxes) of a decrease in the Reference Index over a period of approximately one year, starting from the first business day of the stated outcome period.

⁵ Tim Sablik, Federal Reserve History: Recession of 1981-82, Federal Reserve Bank of Richmond.